Does Mortgage Hedging Amplify Movements in Long-Term Interest Rates?

Abstract

The growth of the mortgage market in recent years raises the question of what effects, if any, the hedging of mortgage portfolios has on the behavior of long-term interest rates. The evidence here is that the ten-year swap rate implied by swaptions becomes more volatile when the prepayment risk of outstanding mortgages increases—most likely because investors expect the hedging of prepayment risk to amplify future interest rate movements. These amplification effects can be considerable, but they are generally expected to persist for only several months.